HOW PRICES ARE DETERMINED

Price Determination

• Prices in a market are determined by the interaction of supply and demand.

• A market is where buyers (consumers) and sellers (producers) come together to trade goods and services.

Demand

• Definition: The quantity of a good or service that consumers are willing and able to purchase at various prices over a period of time. 

• Law of Demand: There is an inverse relationship between price and quantity demanded; as price decreases, demand increases, and vice versa.

• Demand Curve: A graphical representation of the relationship between price and quantity demanded, typically downward sloping from left to right.

Factors Affecting Demand: the demand graph can shift left or right based on the factors listed below

• Price of the Good: If the price of ice cream decreases, people are likely to buy more ice cream.

• Income Levels:

  • Normal Goods: As income increases, the demand for normal goods like new cars increases.

  • Inferior Goods: As income decreases, the demand for inferior goods like instant noodles might increase.

• Tastes and Preferences: If a new health study shows that eating blueberries boosts brain function, the demand for blueberries might increase.

• Prices of Related Goods:

  • Substitutes: If the price of coffee increases, the demand for tea might increase as people switch to a cheaper alternative.

  • Complements: If the price of printers decreases, the demand for ink cartridges might increase.

• Future Expectations: If consumers expect the price of gasoline to rise next month, they might fill up their tanks now, increasing current demand.

Shifts in Demand: 

• Shift in Demand Curve: When a factor other than the price of the good changes (e.g., income, tastes), the entire demand curve shifts.

  • Increase in Demand: The curve shifts to the right. For example, if a popular celebrity endorses a product, the demand for that product may increase.

  • Decrease in Demand: The curve shifts to the left. For example, if a health scare is associated with a particular food, the demand for that food may decrease.

• Effects of Shifts:

  • Increase in Demand: Leads to a higher equilibrium price and quantity. Example: A sudden trend in fitness increases demand for gym memberships, raising prices and memberships sold.

  • Decrease in Demand: Leads to a lower equilibrium price and quantity. Example: A recall on a car model decreases demand for that car, lowering the price and sales.

Supply

• Definition: The quantity of a good or service that producers are willing and able to sell at various prices over a period of time.

• Law of Supply: There is a direct relationship between price and quantity supplied; as price increases, supply increases, and vice versa.

• Supply Curve: A graphical representation of the relationship between price and quantity supplied, typically upward sloping from left to right. 

• Factors Affecting Supply: The supply graph can shift left or right based on the factors listed below

  • Price of the Good: If the price of oranges increases, farmers may supply more oranges to the market.

  • Production Costs: If the cost of raw materials for producing smartphones decreases, the supply of smartphones might increase.

  • Technology: Advances in technology, like automation in manufacturing, can increase supply by reducing production costs.

  • Prices of Related Goods: If the price of wheat increases, farmers might switch from growing corn to wheat, decreasing the supply of corn.

  • Number of Suppliers: If more companies start producing electric cars, the supply of electric cars will increase.

  • Expectations: If producers expect higher prices in the future, they might withhold some supply now, decreasing the current supply.

  • Government Policies: Subsidies can increase supply by reducing production costs, while taxes can decrease supply by increasing costs.

Shift in Supply:

• Shift in Supply Curve: When a factor other than the price of the good changes (e.g., production costs, technology), the entire supply curve shifts.

  • Increase in Supply: The curve shifts to the right. For example, if a new technology reduces production costs, supply may increase.

  • Decrease in Supply: The curve shifts to the left. For example, if the government imposes a new tax on production, supply may decrease.

• Effects of Shifts:

  • Increase in Supply: Leads to a lower equilibrium price and higher quantity. Example: Improved farming techniques increase the supply of wheat, reducing its price and increasing the quantity sold.

  • Decrease in Supply: Leads to a higher equilibrium price and lower quantity. Example: A natural disaster damages crops, decreasing the supply of fruits, raising prices, and lowering the quantity available.

Equilibrium Price

• Definition: The price at which the quantity demanded by consumers equals the quantity supplied by producers.

• Market Equilibrium: The point where the demand and supply curves intersect on a graph.

• Surplus: Occurs when the price is above the equilibrium price, leading to excess supply. For example, if the price of tomatoes is set too high, farmers may have a surplus of tomatoes they cannot sell.

• Shortage: Occurs when the price is below the equilibrium price, leading to excess demand. For example, if the price of concert tickets is too low, there might not be enough tickets to satisfy everyone who wants to attend.

Elasticity

• Price Elasticity of Demand (PED): Measures the responsiveness of the quantity demanded to a change in price.

  • Elastic Demand: Large change in quantity demanded when price changes (PED > 1). Example: Luxury goods like designer handbags have elastic demand, it is not a good that is essential for living so people do not buy it as much.

  • Inelastic Demand: Small change in quantity demanded when price changes (PED < 1). Example: Necessities like insulin have inelastic demand because consumers would have to keep buying it to keep living

• Factors Affecting PED:

  • Availability of Substitutes: More substitutes make demand more elastic.

  • Necessity vs. Luxury: Necessities tend to have inelastic demand, and luxuries are more elastic.

  • Time Period: Demand is more elastic in the long run as consumers find alternatives.

  • Proportion of Income: Goods that take a larger share of income tend to have more elastic demand.

• Price Elasticity of Supply (PES): Measures the responsiveness of the quantity supplied to a change in price.

  • Elastic Supply: Large change in quantity supplied when price changes (PES > 1). Example: Manufactured goods with flexible production processes.

  • Inelastic Supply: Small change in quantity supplied when price changes (PES < 1). Example: Agricultural products in the short term.

• Factors Affecting PES:

  • Time Period: Supply is more elastic in the long run as producers can adjust production.

  • Availability of Resources: If resources are readily available, supply is more elastic.

  • Flexibility of Production: More flexible production processes make supply more elastic.

  • Spare Capacity: If producers have spare capacity, they can increase supply more easily, making it more elastic.